Internalizing the Concept of Too Big to Fail Clearinghouses

Craig Pirrong submits: Patrick Pearson is head of market infrastructure for the EC’s financial market regulator. He apparently hasn’t read the memo declaring that clearing mandates will usher in the era of the Big Rock Candy Mountain:Central clearing . . . is a concept so dear to regulators [sic] hearts that it has become something of a mantra — particularly since the demise of Lehman Brothers and the counterparty risks that were brutally revealed by that event. So when Patrick Pearson . . . stood up to address an ABS conference in London on June 15, his words took some in the audience by surprise. ”Clearing houses don’t reduce counterparty risk,” he stated. ”They simply redistribute it. Central counterparties (CCPs) can act as a channel for risk. Their failure is far more dangerous than the failure of one single counterparty."Complete Story »

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JPMorgan Chase & Co. (JPM) will soon release a paper pushing for wider buffers in clearing houses, as reported by Financial Times. The bank’s concerns stem from the expectations of a market collapse, whose effects are amplified if clearing houses maintain small buffers (or default funds). JPMorgan will issue a warning that the current system is “brittle and opaque” for dealing with potential clearing house failures and that a new framework is required.

Craig Pirrong submits: Oh, yeah. The WSJ seized on Ben Bernanke’s “Puddin’head Wilson” speech about the need to be especially vigilant about the risks inherent in huge CCPs, including those engendered or expanded by Frank-n-Dodd mandates (h/t Carl E and Mark B):

Craig Pirrong submits: On Monday, Fed Chairman Ben Bernanke gave a speech on clearinghouses to the Atlanta Fed’s annual conference. Ironically, Bernanke echoed the theme of my talk at that conference in May, 2009: central counterparties (CCPs, i.e., clearinghouses) could fail, and are a potential source of systemic risk:

Craig Pirrong submits: I’ve written frequently about the problematic evolution of financial market structure under a clearing mandate. One concern is the proliferation of CCPs [central counterparty clearinghouses]. One potential reason for this proliferation is that exchanges will want to control their own CCPs.

Craig Pirrong submits: There are a lot of jokes about economists that go something like: “An economist and a physicist are on the top floor of a skyscraper. Someone runs in screaming ‘the building is on fire. The stairways are all blocked.’ The physicist immediately panics, then looks at the economist, who is amazingly calm. The physicist says, ‘How can you be so calm? We’re all gonna die.’ The economist smiles wanly and says, ‘No we’re not. First, assume a 100-story ladder.’”

Craig Pirrong submits: The U.K.’s Financial Services Authority (FSA) released a report on OTC derivatives market reforms in December. In contrast to most government reports I’ve read on the subject, this one is thoughtful and arrives at pretty well reasoned judgments. It recognizes the trade-offs involved. It is a little too sanguine on the merits of clearing for my taste, but does not recommend mandates.

Editor's Note: The following post comes to us from Stephen J. Lubben, Harvey Washington Wiley Chair in Corporate Governance & Business Ethic at Seton Hall University School of Law.
A clearinghouse reduces counterparty risks by acting as the hub for trades amongst the largest financial institutions.

Craig Pirrong submits: The issue of the systemic risks posed by a clearing mandate that expands the scale and scope of central counterparties has come to the fore of late. Too late, perhaps, but even at this late date it is an advance. The focus of this concern is now on whether CCPs will be too big to fail, and whether they should have access to the Fed’s liquidity provision facilities.